Does Corporate Citizenship Influence Financial Reporting Credibility?

Abstract

The role of financial reporting in the efficient functioning of capital markets depends on investors’ perceptions of its credibility. This thesis examines whether superior corporate citizenship enhances the perceived credibility of financial reporting. It argues that corporate citizenship performance affects the accumulation of social trust, which affects the credibility of the firm or its managers as the source of financial reporting information. Consequently, this thesis hypothesises a positive relation between corporate citizenship performance and the perceived credibility of financial reporting information. It examines three components of corporate citizenship that are not widely considered in prior literature that relates corporate citizenship or social responsibility to financial reporting: tax fairness, wage unfairness and philanthropy. Further, this study evaluates the perceived credibility of financial reports from the perspectives of auditors (who must assess risks attached to management’s financial reports) and investors (as users of the audited financial reports). The study measures differences in auditors’ perceptions of credibility, or information risk, using differences in audit fees. It measures investors’ perceptions of financial reporting credibility in two ways: (1) valuation relevance, which is the extent to which reported earnings explain stock prices (using the Ohlson Model); and (2) information risk, which is implied by the cost of equity capital.

Consistent with source credibility hypothesis, this thesis finds evidence that higher citizenship performance, using all three measures, is positively related to auditors’ perceived credibility of financial reporting information, as reflected in audit fees. The tests using corporate citizenship performance based on corporate philanthropy scores do not provide persuasive evidence in relation to investors’ perceptions of financial reporting credibility. However, the findings show that citizenship performance based on tax fairness and wage unfairness is significantly associated with investors’ perceived information relevance (using the Ohlson test) and perceived information risk (using the cost of equity test). Overall, the analysis provides strong evidence that corporate citizenship performance is positively associated with the credibility of financial reporting.